After taking over as Toyota president in June 2005, Katsuaki Watanabe regularly warned of the dangers of complacency creeping in at the Japanese automaker. But until recently, it was a tough message to get across. The company was doing too well: In the year through March 2008, Toyota sold 8.9 million vehicles, an increase of 32 percent over five years, while its net profits rose 53 percent, to $17 billion. This year it will likely overtake GM to become the world's largest carmaker.

These days, though, Watanabe need only point to Toyota's stock price to keep employees' feet on the ground. Since the beginning of the year, Toyota's shares have fallen 37 percent. While roughly in line with Japan's benchmark stock index, the performance isn't much better than troubled GM, whose stock is down 39 percent. And Toyota's recent sales, though not nearly as bad the Big Three's, hardly instill confidence. Through September, sales were down 10 percent in the U.S. and were sluggish in Europe. In Japan, where Toyota's market share is more than 40 percent, car sales will likely fall short of last year's figures, which was the company's worst in more than two decades. Even in China, where the automaker aims to increase sales 40 percent this year, the numbers aren't looking as promising as Toyota's top brass had hoped.

Some analysts are sounding the alarm. In an Oct. 10 note to investors, NikkoCitigroup auto analyst Noriyuki Matsushima predicted "a sudden and substantial earnings decline" for Toyota. "We believe Toyota needs to draft a new strategy that changes its existing course and includes initiatives to secure appropriate sales volumes," he wrote. Lowering his projections for the current fiscal year, Matsushima expects Toyota to post operating earnings of $11 billion, a 50 percent decline compared with the year that ended Mar. 31, and $5 billion less than the company's projection.

Time for investors to bail out? Not exactly. Even if Toyota's earnings drop by half this year, the company's operating profits are still likely to exceed $10 billion. And with a solid balance sheet, more than $20 billion in cash, and a slew of new car initiatives, Toyota is better placed than most automakers to weather economic uncertainty. "Once (Toyota executives) have made the decision to do something, they can get on and do it without having to arrange financing," says Andrew Phillips, an analyst at KBC Securities in Tokyo.

For now Toyota's problems seem minor compared with the Big Three's — and it's moving to keep it that way. Toyota's bulging coffers will help it most in the U.S. There, it's using the cash — $3 billion at its U.S. financing unit, as of the end of June — to plug falling sales. Facing an increasingly severe slowdown and growing inventory, Toyota on Oct. 3 began offering for one month interest-free financing on 11 models, including the Corolla, Camry, and Tundra full-size pickup. The risk, say critics, is that zero-percent financing could undermine car-resale values and hurt the brand if the company decides to extend the offer.

Toyota is also taking radical steps at its North American factories. After opening a plant for big Tundra pickup trucks in San Antonio in 2006, the company has since curtailed production. It also has suspended production at three U.S. plants for three months in August to retool them so there's more emphasis on smaller, fuel-efficient models.

(It's not letting go of the 4,500 workers, though; they're keeping busy by doing everything from training programs to filling in at assembly lines elsewhere or volunteering in local communities.) And for the first time, its hot-selling Prius gas-electric hybrid will be built in the U.S., at a plant in Mississippi — a move that will help it meet a target of selling 1 million hybrids a year early in the next decade.

Back in Japan, Toyota is finding ways to trim spending. To counter the rising cost of raw materials, Toyota has begun working with steelmakers to reduce the 4 million metric tons of steel it uses each year. That's led to a 20 percent reduction in the steel sheets it buys from suppliers, the company says. Toyota has also asked group companies and suppliers to submit ideas for lowering costs.

Perhaps more important, though, is Toyota's pipeline of new vehicles, which will incorporate more hybrid models. A new Prius next year will likely be shown at the North American International Auto Show in Detroit in January, and two more hybrid models, along with hybrids for the luxury Lexus lineup, could be available by 2010. "There's no magic formula to cope with the sudden changes in the business environment," says Tatsuo Yoshida, an analyst at UBS (UBS) in Tokyo. "But Toyota has one of the widest product portfolios, and it invested heavily in hybrids as well."

Toyota's not betting solely on hybrids. It has high hopes for its new $14,000, 1-liter iQ ultracompact car, which it will begin selling on Nov. 20 in Japan and early next year in Europe. The company is wagering that the iQ — slightly longer than the Smart Fortwo but with seating for three adults — can change the perception that small vehicles are lower-quality. That's important if the world's car buyers shift to smaller vehicles, which tend to offer lower margins than larger models.

The iQ is the result of a five-year project to find new ways of creating more space in smaller cars. The result is a host of new technologies that make the tiny car feel roomy on the inside. The iQ, for example, saves space by placing its flatter fuel tank under the floor instead of the rear seats. Its air-conditioning and heating system is 20 percent smaller than the model used in the Yaris compact car. Hiroki Nakajima, chief engineer of the iQ, says applying the know-how to other cars built on the same platform might produce the unthinkable — a compact car that seats seven people.